Macroeconomic survey

Since the transition from a market economy Latvia’s economic development has been affected by two major events – firstly, a near hyper-inflationary period in 1991/1992 and, secondly, a commercial banking crisis in mid-1995. In each case recovery was relatively rapid and sustained. Recovery was achieved through, strict monetary and fiscal policy, in the first instance; and in the second by implementing reserve requirements, and restrictions on deposit taking and credit granting.

A summary of selected macroeconomic indicators for Latvia is presented in Table 4.1.1 immediately below.

The vigorous corrective measures prompted by the inflationary events of 1991 have been successful. The domestic price deflators and inflation have stabilised at levels that are more manageable. For the 12 months of 1997 inflation stood at 7.4% - amongst the lowest of similar transitional countries. One government report (MOE, 1998, p24)) projects inflation to drop to 4% over the five years to the year 2003.

Other statistics demonstrate Latvia’s efforts to combat inflation. Of candidate states intent on accession to the EU, none currently have a lower inflation rate or lower projected rate for the near future. Past private consumption deflator (inflation) rates are presented in Table 4.1.2 below.

The make up of GDP has also undergone significant changes in Latvia in very recent years.

A major change is seen in the distribution between public and private sector contributions to GDP. Statistics indicate private sector performance has recently dominated, growing from 34% to 51% between 1994 and 1996, and currently (1998) standing at 63% of domestic product. This is consistent with government’s strong commitment to restrain its own expenditures until circumstances permit otherwise. Also consistent with this philosophy, Latvia’s total debt (internal plus external), as a percentage of GDP, stood at 11.9% (6.6% plus 5.3%), which was one of the lowest in Eastern Europe, and meets the Maastricht criteria for EU members. A fiscal surplus was realised in 1997 and projections for the next five years suggest deficits of only one-half of one percent – an admirable performance not matched in countries similarly in transition.

Overall, manufacturing and industry have experienced steady growth since 1995 – averaging 25.7% and 30.1%, respectively, and settling around 21.5% and 26.7% in 1997. Over the last three years, growth in wood processing has exceeded these levels (see following section).

An indication that Latvia is continuing to pursue the transition to a competitive market economy is its stated aim and implementation of measures consistent with those required for accession the to European Union.

Manufactured outputs of forest sector activities appear in three tables following below.

The first two tables presented above show vigorous growth in wood, wood products, and paper and allied products. The performance of the furniture sector is definitely declining in most areas – though this should not be considered a reflection of its potential.

Trade

In 1997 and 1998 wood and wood products (excluding furniture) contributed 32.3% (MOF, 1998, 1999) towards Latvia’s export earnings – a growth of 48.6% over that of 1996. Latvia’s Central Statistics Bureau’s statistics gives the contribution of the forest sector (including furniture, and paper and related products) to exports as 35%.

In the short-term at least, the forest sector is and will remain a major player in Latvia’s economy. This may be more so than suggested by the figures presented here. Overall, this consultancy has been frequently reminded and has found evidence to suggest that the statistics measuring the performance of the forest sector in Latvia likely significantly understate the current and potential significance of that sector to the country’s economy. The primary reasons given for this are:

non-reporting by an unknown (but presumed large) number of processors (mainly due to the large number of small enterprises that are not registered)

understating reported figures to minimise taxation liabilities, employee remittances, etc.

In some regions, the percent contribution of forest sector activity to employment and incomes significantly exceeds national figures. Attempts to illuminate this issue have been initiated by this project’s economic component and will only become available for further analysis later in the course of the ROL/FAO project.

Domestic demand for the end products of forest activities is limited in Latvia. Worldwide, personal "house (construction) starts" are a closely watched statistic because of their impact upon domestic wood product sales. Latvian activity in housing starts is not likely to "take off" until income levels rise and the State’s participation in the provision of housing is fully privatised. EU average figures for annual housing starts (approximately 50 units per 10,000 of population) applied to Latvia would predict over 10,000 units annually – an obviously huge domestic market. The figure for Latvia in 1995 was 7 units per 10,000 of population- or about 1,700 units.

The total of Latvia’s trading partners in 1997 reached 144 countries. Wood product trade revolves around about a dozen key markets, which are included in representative trade statistics shown in Table 4.2.2.1.1

Because of low domestic demand, Latvia relies heavily upon export markets to sell its forest products. Well over three-quarters of the forest products produced in Latvia are exported – in recent years mainly to the EU. Exports to non-EU countries dropped to 10.5% in 1997 - 2% to CIS countries and 8.5% to others.

Until very recently, Latvia’s two-way trade (exports and imports) was highest with Russia. In 1997, Russia imported a fifth of all of Latvia’s commodity exports. Fluctuations in trade between these two countries will continue to persist – primarily related to evolving political and economic circumstances in the Russian Federation. Specific instances of the impact of the RF’s currency crisis culminating in August of 1998 became immediately evident in Latvia. With increasing levels of trade taking place in other markets, Latvia’s exposure to such crisis remains manageable.

A pronounced shift towards European markets remains in place and is growing. From 1996 to 1997 trade in wood products with the EU states has gone up 53.4% and now constitutes 54.4% of all Latvian exports to this market. The main importers of Latvian wood products are the UK, Germany and Sweden. The European Union imports 89.9% of all of Latvia’s wood products.

Latvia concluded an agreement with the remaining four members of the EFTA in June of 1996. Additionally, steps to complete Latvia’s accession the European Union are clearly defined and in progress.

Latvia also holds MFN status with a number of nations with which it has bilateral agreements. Not the least of these is with neighbouring Baltic States with which progressive steps toward the creation of a Baltic common economic area have been taken. Latvia is clearly moving to integrate itself into the international arena to largely comply with prevailing accords and expectations.

Target levels of public sector employment in Latvia will eventually be determined by the distribution of forest management and supervisory roles between public and private sector entities. Greater efficiencies are experienced where private sector entities assume all operational and even many management roles.

Significantly reducing current public sector employment levels in Latvia’s forest service is a predictable outcome of sectoral optimisation efforts. This may not occur in one single retrenchment exercise. However, Latvia’s ratio of public sector forestry employees to AAC is high. Finland and British Columbia, which have far more demanding standards of forest management, have similar sized Forest Services and manage 8 and 9 times as much AAC. Reduction in employment levels is consistent with the government’s aim to reduce its public sector wage bill.

The unavoidable necessity to downsize would accompany the introduction of new institutional and management structures, proposals for which are being developed by the ROL/FAO project. The goal would be to introduce a higher level of professionalism amongst the remaining complement of staff. Old non-productive or inefficient workplace "cultures" would be replaced by more performance-oriented management and results oriented processes. In this respect, steps have been initiated to seek the participation of both public sector managers and private sector operators (licensees, mill owners, etc.) in the development of new approaches to optimising forest sector management, decreasing costs and optimising revenues.

Latvia has 2.88 million hectares of commercial forests and an annual allowable cut of 8.6 million m³, which translates to about 1 ha, or 3.4 m³ per person. All areas of the country have forest cover in excess of 25% and most in excess of 50% (see following page) – though south-central and south-eastern areas are relatively less well endowed.

Especially in rural areas, forests are very significant to local economies. Forestry and its integration into Latvian social and economic traditions is long established – which fosters the desirability of continued activity in this sector. Not the least of this continued presence is in the provision of "social" wood for fuelwood purposes.

Employment levels in the country’s forestry sector have been decidedly more stable in the public sector than elsewhere. In other sectors, privatisation, rationalisation and redundancies have produced noticeable changes – prompting the question, "With the dynamic activity witnessed in the forest sector in recent years why has so little changed in the way in which forests have been manage?" Admittedly, within the very recent past, major changes have taken place in the senior management with the SFS.

Employment figures for recent years appear in Table 4.3.1 immediately below.

There is some question as to the representativeness of these figures – though they were directly extracted from the indicated sources. The forestry employment figure, in particular, was deemed to understate the actual employment level in the primary (harvesting and silviculture) sector.

Average gross wages in the forest sector (manufacturing) are above national averages (CBSa, 1997; CBSf, 1998). However, the wages of public sector employees in forestry – of which there are over 3,000 – do not meet national averages. Where wages are unacceptably low, there is considerable incentive to extract "unofficial" payments or other benefits where opportunities exist, especially where risk of detection is low, and risk of sanctions even lower.

Statistics on employment trends, overall, for Latvia are presented in Table 4.3.2 immediately below.

The presence of corruption is tacitly acknowledged in Latvia. Inducements (monies or otherwise) are routinely expected and paid to facilitate routine administrative or operational procedures. Anecdotal evidence was received during the consultancy that suggested specifically that, "corruption is rampant, and involves relatively significant payments" at the forest region level ("Head Forestry" level, in Latvia) and at subregional "district" levels. The subtleties of some payments included routine considerations "in kind" (meals, travel, etc.) without which approvals, etc. were delayed if not actually denied.

This report need not outline further inventiveness at public sector corruption. It is a well-known issue in former command economies and Latvia is taking steps to deal with it – including specific anti-corruption legislation.

Corruption of the magnitude suggested in Latvia can only persist with the tacit approval – if not direct participation – of senior personnel. It is naïve to think otherwise. A reorganisation of public sector forest administrations – with wide-scale retrenchment of senior personnel, and subordinates, is frequently unavoidable to extricate corruption. The consequences of corrupt practices can include:

misdirected economic rents (lost wages, government revenue, etc.)

inefficiencies throughout management and operations activities

decreased forest productivity

underutilization and wasted resources

misapplication and misappropriation of budgetary resources

institutionalisation of bad business and financial practices

Each of the above consequences can have a direct impact on the level of total revenues derived from forest land and timber resources – and, more importantly on driving otherwise more honest participants out of the sector.

Worker Productivity

The macroeconomic significance of worker productivity may be most obvious by contrasting worker performance between countries or regions. The economic component will eventually undertake such studies.

Productive forestry sectors tend to stand out as low cost usually high quality producers. Their standards of performance derive from the integration of technology and training. Capital investments are common, as are expenditures on research and development. The overall consequence is that the workforce maximises its own contribution to national value-added – and thus to foreign exchange earnings, taxes, savings and investment.

In the earlier phases of transition, the potential for productivity gains from training and technology transfer may be higher than during later phases when most of the benefits may already have been realised. Early gains can arise from simple changes in operations management, staffing, monitoring and training. Which changes to adopt is dictated by the ability to financing their implementation, the prospects for their success, their level of contribution to earning or productivity gains and their relationship to other process dependent upon them.

Training and applied research

Investment in Latvia’s human capital are unavoidable – even in the short term – if productivity increases are to be realised. Even with existing fixed capital, significant increases in productivity can be predicted where training and technological know-how transfer occurs.

Research, development and applied research are the unavoidable complement to training. Especially in the achievement of maximum biological productivity of Latvia’s forests – this is a critical need. There appears to be considerable opportunity to modify existing and introduce new forest establishment and stand tending prescriptions – demonstrably successful elsewhere in similar operating and biological conditions. The consequence of not training local university instructors and field level foresters in the application of these techniques is, of course, sub-optimal productivity of forest land.

The overall level of capital investment in Latvia has yet to return to 1990 levels. It has been increasing very slowly since reaching its lowest post-independence levels in 1993. It appears to have, however, grown marginally faster than that of GDP – which has averaged 2.4% annually since that year. Accumulated capital in the manufacturing sector was out-paced by almost 3 to 1 by the services sector. Capital investment for 1997, as a percentage of GDP stood at 19.3%. For the same year the forest products manufacturing sector’s contribution stood at 3.86% of GDP.

Revaluation during privatisation gave rise to higher levels of capital - not because of growth in real investments – but because of the application of more broadly accepted accounting and business valuation practices. Additionally, the conversion in 1992 from Russian roubles to Latvian roubles (1:1), and then in 1993 from Latvian roubles to Latvian lats (200:1) also affected accounting "book" values of listed assets. Economic reforms affecting measurements of business performance had a similar effect. A further difficulty is the absence of an adequate number of years of observations to constitute a representative time-series for certain credible analysis

A summary of capital investment in forestry and in wood, paper, manufacturing and related products appears in Table 4.5.1 immediately below. The table will be completed, as additional data becomes available from conventional state sources and from participating firms as they are integrated into project activities.

Statistics on capital investment are believed to understate the actual investment in fixed capital that has taken place in forestry and downstream processing. This is suggested by the results of a an ad hoc survey undertaken jointly by the CSB and the SFS (CSB,f, 1998) which gave figures in excess of those supplied by more routine data collection procedures.

For a small number of firms, there is some evidence of high quality long-term capital investment – much, if not all of it, having foreign origins. The wood-processing sector was the second largest recipient of FDI in Latvia in 1997 – accounting for 20% of that figure. Table 4.5.2 below presents major recent or planned investment in Latvia’s wood manufacturing sector.

The pattern of resource extraction, investment, product sales and earnings seen in Latvia is not atypical for where forest sector development is "renewed" or "opened-up" - and repeats patterns seen elsewhere.

Initial investment where access to timber resources is "liberated" or "opened –up" is typically directed towards timber harvesting, and forwarding and hauling equipment to permit the extraction and transport of logs to ports or river or rail transhipment depots. Initial investors are often established wood processors elsewhere or local log brokers. In either case, each is involved in an arbitrage transaction by buying raw unprocessed logs at relatively low prices and relatively low value-added – and selling them elsewhere at higher prices in external markets. The issue of log exports is discussed later in this report.

Fixed capital depreciation

Latvia has a large amount of already "consumed" capital equipment that conceivably is - or shortly will be - in need of replacement. Ordinarily, firms establish depreciation accounts to which accrues annually an amount equal to the cost of future replacement purchases. Additionally, depreciation must be accounted for to avoid misrepresenting asset values, capital productivity and net earnings.

Transition between economic systems imposes the need to evaluate existing fixed (or physical) capital and establish schedules for its depreciation. In Latvia’s case, the valuation exercise was necessarily undertaken twice – once from old roubles to new roubles and once from new roubles to lats. This lead to its own peculiar difficulties in capital appraisal exercises.

It remains to be seen how firms facing the expiration of the useful life of their sawmilling equipment, etc., especially the older former state enterprise units, will respond in terms of capital replacement (investment). The cost structure of their operations will most certainly change – potentially increasing the risk to business failure or buy-outs by more competitive firms.

Fixed capital productivity

Except by direct contact with firms involved in various sub-sectors, it is difficult to judge the quality of those investments that have taken place in Latvia in the forest sector. It is clear that "state of the art" equipment has been installed and is operating in a number of firms. It is also not surprising that there is a reluctance to demonstrate fully the financial success of such installations. This is not unexpected in a market that is clearly open to entry by other participants, and especially when current legislation to provide statistics on productivity can be avoided without consequence or is ineffective in capturing the relevant data.

Under normal conditions, where capital productivity increases, employment levels fall. For other reasons, it is difficult to ascertain, within the forest sector, whether this has occurred. It does appear that, employment levels have not risen in conjunction with increased capital investment – which would be consistent with expectations.

The ROL/FAO project’s economic component has initiated discussions with a small number of domestic producers to ascertain the magnitude of capital productivity here. Most instructive in this analysis will be a comparison of local productivity with that of other wood producing countries. This will give an initial approximation of Latvia’s potential competitiveness.

Taxation

Taxation reflects another area in Latvia where government has sought to establish sound fundamentals upon which to base economic planning and development. General taxation principles are determined by the Law on Taxes and Dues adopted in early 1995. The rates themselves are consistent with those found in the broader geographic region in which the country resides (see Table 4.5.3.1 below).

Late payments fees and re-financing rates (4% since April 1997) are also clearly specified.

In the forest sector, export taxes and import duties and dividend taxes may be most significant. Many countries impose taxes, or provide relief from taxes, to direct the development of their economies. Tax holidays are common to encourage capital inflows for investment. Taxes can be differentially applied to affect a level of protection upon local industries or individual enterprises. Even in the presence of "common markets", members may retain considerable scope to use taxation in protectionist ways – in spite of otherwise considerable harmonisation of tax policy.

Taxation of exports of raw materials (or semi-processed or intermediate products) may be an effective way to promote their further local processing. Exporting roundwood, for instance, sacrifices the value-added – wages, dividends, profits – that might otherwise have accrued to domestic accounts.

An export tax affects the distribution of value added as well as its absolute level within the country. Exporters enjoy higher profits from the difference between export and domestic selling prices. Where a "residual value" stumpage calculation mechanism is in place, state stumpage receipts are lower. Wages, dividends, profits and even taxes resulting from further processing are foregone by each of their respective recipients.

Admittedly, the export of logs does also generate wages etc. – but rarely to the level of secondary and further processing activities. In addition, there is an interesting "flip side" to the issue of log export taxes!

For domestic log buyers, an export tax constitutes an implicit subsidy. It effectively depresses the domestic selling price of round wood to levels below its international selling price. Industries developing under such terms are, in part, protected from competition – and potentially less able to compete under other circumstances.

Therefore, if an export tax is not imposed the state is contributing to the exporter’s profits at the expense of it own revenues and those of the domestic processing sector. If an export tax is imposed, the state is contributing to the domestic processor’s profits at the expense of the exporter!

The solution to this issue depends partly upon the make-up of the existing processing sector. If its efficiency is nearing international levels, it may not be much affected by the price differential. Final upgrades to reach such levels could be funded by redistributing export taxes to the processing sector as loans or grants.

Where major improvements are needed to match the efficiency and quality standards of foreign competitors, a different strategy is required. Collected revenues can be assigned to specific industry development activities. The goal should be to encourage as rapid an advancement as possible as a competitive industry will maximise benefits overall and requires less state intervention than otherwise – once established.

Export quotas can also be used effectively to direct industry development – though the attendant revenues are again distributed as explained earlier. Of course, a combination of quotas and taxes may be most flexible.

Latvia has adopted the basic approach of levying VAT at the point of final consumption. VAT paid for intermediate inputs is therefore subject to rebate – or may be deducted from VAT taxes that are still otherwise payable. Additionally, certain goods and services are subject to a "zero" percent tax rate. Of these, the following may be relevant to the forest sector:

supply of goods or services outside Latvia (e.g. forest product exports)

services related to supply of goods outside Latvia

supply of goods and services related to the maintenance of and service of international transportation.

Given the relatively low domestic demand for wood products, VAT deductions on construction fees and repair of real estate may be highly significant. Such deductions can constitute almost a fifth of a project’s materials budget – a difference that may be substantial in calculating profitability.

Increasingly, small and medium sized enterprises are forming the backbone of development activities. Taxation policy and practices favourable to SMEs are a high priority even in very well developed economies. Latvia’s value-added taxation policy with respect to SMEs may eventually warrant a review to ensure favourable treatment to this component of its economy in all sectors.

The performance of Latvia’s financial sector is widely accepted as being amongst the most stringently controlled in the region and amongst similar "transition" economies. For small or medium-sized enterprises, acquiring credit for is still difficult. Commonly, the reasons for this lie amongst the following:

lack of secure collateral

absence of markets for mortgageable assets

limited secondary markets for commercial financial "paper’

absence of credit performance history of applicants

unstandardised accounting and auditing procedures

absence of syndicating mechanisms.

Loan interest rates

From the perspective of the applicant, the cost of money, for both short and long-term loans, may be the most significant factor in acquiring credit. Average weighted interest rates for recent years are presented below.

Long and short-term loan interest rates for 1997 tracked each other very closely. From January to May they dropped uniformly from around 20%-22% to about 15% - after which they ranged between about 12% to 15% to year’s end.

Other interest rates have declined considerably. Discount rates for government short-term bills have fallen to the level of 3.4% - 5.6%, and the latest two-year bond issue has been sold at the discount rate of 7%. The Bank of Latvia lowered its refinancing rate to 4% in April 1997. Inter-bank money-market rates are constantly within the range of 3% - 5%.

Savings

Bank deposits available for credit would be higher in Latvia if the proportion held as demand deposits were shifted to term instruments. In 1996 demand deposits constituted 82.5%, and 78% in 1997.

The propensity to save is lowest where incomes are not adequate or just barely so, to meet daily living expenditures. Incomes generally rise as workers’ claims to their share of value-added increases. Of course, that claim can only increase if value-added increases.

In Latvia domestic savings deposits, which ordinarily are recycled as investment loans to entrepreneurs, have, in fact, dropped to half the level they held five years ago and currently stand below 10%.

Savings in deposit accounts become the source of loans to entrepreneurs to finance their investments. Increased investments should translate into increased worker productivity so that the process described briefly here is self-reinforcing, other considerations aside. The consequence overall is clearly an increase in credit availability. Representing less than 4% of the countries work force, the overall contribution of forestry sector workers to deposit accounts is not currently significant. However, as this percentage increases and as forest sector wages rise this group's significance as savers may change.

Since 1994 the lat has been unofficially pegged to the SDR (XDR). It has been effectively managed against speculative market activities three times since then – including in 1995 during the "banking crisis" of that year. Its performance against other relevant currencies appears in Table 4.7.1 below.